Editor’s Note: Today’s installment of Energy Investing Weekly marks Roger Conrad’s first written article as co-editor of Energy & Income Advisor. The founder and former editor of Canadian Edge, MLP Profits and Utility Forecaster, Roger Conrad will contribute his expert knowledge of master limited partnerships and Canadian energy stocks. In tomorrow’s issue of Energy & Income Advisor, Roger will highlight his favorite Canadian energy stocks.
I started tracking Atmos Energy Corp’s (NYSE: ATO) predecessor, United Cities Gas, in 1992. The natural gas-distributor pursued what was considered a novel strategy at the time: relying on acquisitions to build scale, reduce costs and drive earnings growth. The company targeted systems in rural parts of the Sun Belt that were growing their populations.
Atmos Energy was also one of the first US gas utilities to get regulatory approval for weather-normalized rates that guarantee a steady stream of cash flow regardless of unseasonably warm or cold temperatures. Under these agreements, fluctuations in natural-gas prices are passed directly to consumers without requiring the utility to file a rate case.
In the intervening years, Atmos Energy has pared its geographic footprint and now generates about two-thirds of its earnings from Texas.
The firm added a 6,000-mile regulated Texas intrastate pipeline network to its asset mix in 2004 and in 2005 profitably disposed of its former stake in propane distribution networks that are now operated by AmeriGas Partners LP (NYSE: APU). Over the past two years, Atmos Energy has divested its regulated natural-gas systems in Missouri, Illinois, Iowa and Georgia.
Despite the changes to Atmos Energy’s asset base, the stock’s appeal to investors has remained the same: The firm boasts a secure franchise and demonstrated the resilience of its underlying business by growing its quarterly dividend throughout the Great Recession.
This relative strength limited the stock to an 11 percent loss in 2008–an impressive feat in a tumultuous year that saw the Dow Jones Utilities Average give up 28 percent and the S&P 500 tumble 37 percent. Investors soon came to their senses–at least as far as Atmos Energy is concerned–enabling the stock to wipe out its loss by spring 2009 and post a total return of 30 percent on the year.
However, investor demand for securities that offer above-average yields has propelled the share price of Atmos Energy to an all-time high and reduced the stock’s current return to an all-time low. At these levels, investors must ask themselves whether the utility’s stable business and steady growth justify the stock price surging 36 percent higher over the past 12 months. Do shares of Atmos Energy offer additional upside, or will the bottom fall out when the buying momentum stalls?
These aren’t idle questions in a market that has severely punished high-flying names whose earnings fall short of expectations. After months of positive momentum, Atmos Energy’s share price has outrun any reasonable expectation for growth in the underlying business.
Check out this table tracking Atmos Energy’s financial metrics, valuation and stock performance over the past 10 years.
Atmos Energy has clearly become a more valuable company over the past decade, with the book value per share increasing by 50 percent, dividends up 16 percent and earnings growing by 45 percent over this period.
The utility’s revenue has been erratic–a fact of life for any gas distribution company. In its 2012 fiscal year, Atmos Energy recorded sales that were roughly half 2008 levels; five ago, the price of natural gas was several times higher. Although revenue intake will fluctuate because customers bills rise and fall with changes in natural-gas prices, Atmos Energy’s bottom line is unaffected by shifting commodity prices.
What management calls “gross profit,” or revenue minus natural-gas costs, better encapsulates the firm’s growth, though the evolution of the Atmos Energy’s business mix complicates year-to-year comparisons. The recent sale of the company’s Georgia operations, for example, should boost overall profitability but will cut the number of customers served, which will eat into revenue and potentially reduce margin.
No matter how you slice it, Atmos Energy’s business growth hasn’t come close to matching the stock’s recent run-up. A decade ago, shares of Atmos Energy yielded 5.5 percent. But at the stock’s current quote, the company would need to increase its dividend by 74 percent to achieve its former yield. Assuming that Atmos Energy continues to grow its dividend at an annual rate of $0.02 per share, 50 years would pass before its payout reached this target.
Although a price to book value of 1.59 appears modest, this valuation metric is up sharply from November 2012, when the stock traded at a multiple of 1.28.
To be sure, Atmos Energy’s business is thriving. Earnings in the company’s fiscal second quarter were good enough for management to raise its full-year forecast by 2 percent, to between $2.45 and $2.55 per share. Capital spending of $770 million to $790 million in fiscal 2013 will drive growth, with a good portion of this outlay automatically recovered under Texas’ Gas Reliability Infrastructure Program. The company also shaved roughly 10 percent off its interest costs.
Rate cases are always worth watching. But Texas remains a favorable regulatory climate for utilities, as are the seven other states in which Atmos Energy does business.
What’s the problem? A skyrocketing share price translates into higher earnings expectations; it won’t take much of a setback for Atmos Energy to disappoint. Wall Street analysts have acknowledged this risk, with the stock catching three downgrades already this year. I’m not a crowd follower, but this time I agree with the Street.
Atmos Energy isn’t the only dividend-paying stock that’s rallied beyond a reasonable valuation–and with bond-focused mutual funds adding equities to boost yields, this momentum could continue for a while. But when the buying stalls out, the share price of Atmos Energy could pull back in a hurry.
My prescription for dividend-focused investors is to pursue an “Anti-Mo Strategy.” The first step is to avoid chasing dividend-paying stocks that have rallied beyond any semblance of fair value. I consider a combination of regulatory, financial and operating criteria to assess the underlying health of utility companies. I then compare that to reasonable expectations for an annual return, which I define as dividend yield plus annual dividend growth.
Ideally, Atmos Energy and other high-quality names should offer an estimated forward return of 8 percent to 10 percent. Based on its decade-old policy of increasing the dividend per share by $0.02 annually, the expected return for shares of Atmos Energy is less than 5 percent at the stock’s current quote. That’s hardly an appealing prospect when you consider the risk of a pullback.
Step two is to play offense. If you’re like most income-seeking investors, you prefer to buy and hold stocks for the long haul. I definitely fall into that camp; my best personal investments have all been stocks that I’ve held for at least a decade.
Stocks that appreciate to the point that they account for a disproportionate share of your portfolio can lead to concentration risk; consider taking some profits (not all) on your biggest winners and placing a buy limit order at what you’d consider a dream price.
The lower the price, the less chance your order will be filled. However, a 25 percent to 30 percent correction is a reasonable expectation for shares of Atmos Energy and other dividend-paying stocks that have been bid up to crazy valuations. And if your buy limit order is executed, you’ll own more shares of a great company at an above-average dividend yield.
Following my Anti-Mo strategy will take patience. And because long-time holders of in-demand income stocks are sitting on substantial gains, this approach will work best in a tax-advantaged account.
Forget near-term momentum and focus on the longer-term trend. Dividend-paying stocks traditionally have tracked growth in their quarterly payout. Investors who followed my lead and accumulated high-quality income stocks in 2009-10, when share prices lagged expected dividend growth, have been rewarded handsomely. But caution is in order: Many of these stocks trade at valuations that have outstripped potential dividend increases.
Elliott and Roger on Aug. 31, 2021
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